Non-publicly traded securities such as loans and privately placed securities 2.2 Benefits of Regular Cash Flows 2.3 Inflation Hedging Potential Fixed-income investments often provide reg
Trang 1“INTRODUCTION TO FIXED-INCOME PORTFOLIO MANAGEMENT”
2 ROLES OF FIXED INCOME SECURITIES IN PORTFOLIOS
Fixed income when combined with other asset classes
• provide diversification benefits
• may significantly lower portfolio risk Note: Correlations among asset classes or volatility of asset class returns may ∆ overtime or due to ∆ in capital market dynamics
2.1 Diversification Benefits
1 INTRODUCTION
Fixed income markets incorporate:
i Publicly traded securities (such as commercial papers, notes, bonds)
ii Non-publicly traded securities (such as loans and privately placed securities)
2.2 Benefits of Regular Cash Flows
2.3 Inflation Hedging Potential
Fixed-income investments often provide regular cash-flow streams that can be sued to fund the projected future liabilities by matching the timing and amount of those liabilities
Inflation-linked bonds:
• provide inflation-hedging benefits
• are suitable for investors with long-investment horizon
• can result in superior risk-adjusted real portfolio returns
• Their return has two components: Real return plus additional return (directly linked to inflation rate)
• Their return volatility is relatively lower than conventional bonds & equities
Various Bonds and Inflation Protection
Fixed-coupon bonds
Floating-coupon bonds
Inflation-linked bonds Coupon Inflation
unprotected
Inflation protected
Inflation protected
Principal Inflation
unprotected
Trang 2Two broad classifications of fixed income mandates are:
Liability-based mandates, also known as, structured mandates, asset/liability management (ALM), or liability-driven investments (LDI)
Total return mandates
3 FIXED-INCOME MANDATES
• Simplest immunization approach to match precisely all future liability streams by cash flows from fixed income investments
• this approach has no underlying assumptions
• In reality, perfect cash flow matching is difficult to achieve
3.1.1 Cash Flow Matching
•Full replication is done by owning all the bonds in the index in the same percentage
as the index
•Full replication is inefficient, costly
& difficult to implement
The objective
of this approach is to outperform the index by small risk factor mismatches
3.1.4 Horizon Matching
3.1.3 Contingent Immunization
3.1.2 Duration Matching
A hybrid approach that combines immunization with active
management approach when there is a surplus available i.e when portfolio value > PV of liabilities
A hybrid approach in which liabilities are sorted into short and long-term liabilities
• For short-term liabilities apply cash flow matching approach
• For long-term liabilities apply duration matching approach
is an immunization approach that match duration of assets and liabilities in a way that when interest rates rise or fall,
∆ in bond portfolio’s market value closely match ∆ in the liability portfolio
Conditions: Two conditions that need to be satisfied:
i Bond portfolio duration must be equal to the liability portfolio duration
ii PV of bond portfolio’s assets must be equal to the PV of bond portfolio liabilities at current interest rate levels
Limitation: it protects against only a parallel change in yield curve
3.2.3 Active Management
The objective of active management is
to outperform the underlying benchmark
by opting for large risk factor mismatches on duration, sector weights and other factors
3.2.1 Pure Indexing
3.2.2 Enhanced Indexing
3.1 Liability-based Mandates
3.2 Total return Mandates
Total return mandates are generally structured to either track or outperform
a benchmark
Trang 34.1 Liquidity among Bond Market Sub-sectors
4.2 The Effects of Liquidity on Fixed-Income Portfolio Management
Liquidity varies among different bond market
subsectors
Sovereign government bonds are more liquid
than non-sovereign government bonds or
corporate bonds because of the following
features
• Large issuance size
• Well organized issuers
• Treated as benchmark bonds or collateral in
the repo market
Some common features of corporate bonds
include the following:
• issued by various companies
• represent a wide range of credit quality
• issued by infrequent issuers are often less
liquid than the bonds issued by companies with many different issues
• small sized issues are less liquid than larger
issues
• bonds with longer maturity are less liquid
than nearer-term bonds
4 BOND MARKET LIQUIDITY
4.2.2 Portfolio Construction
Investors’ liquidity considerations are important in portfolio construction because there is a trade-off between liquidity and yield
• Pricing in bond markets is less transparent than equity markets
• Generally, bonds are traded using recent price and value information
• ‘Matrix pricing’
approach is usually used for
infrequently traded bonds
4.2.1 Pricing
4.2.3 Alternatives to Direct Investment in Bonds
Fixed income derivatives are often more liquid than their underlying bonds Investors can use two types of fixed-income derivatives:
i Derivatives traded on exchange (e.g futures, options on futures)
ii Derivative traded over-the-counter (e.g
interest rate swaps, credit-default swaps)
Exchange-traded funds (ETFs)
and pooled investment vehicles are also used as alternative to individual bonds
Five Components of E(R) ≈ Yield income + Rolldown return + E(∆ in
price based on investor’s yields/yield spread views) − E(Credit
losses) + E(currency gains & losses)
Where,
i)Yield income (or Current yield) =
ii) Rolldown Return =
= [-MD× ∆ ]+
∆
iv) Expected credit losses = bond’s probability of default ×
expected loss severity
• Fixed-income return decomposition
is an approximation
• Model assumes that all intermediate cash inflows are reinvested at the YTM
• Model ignores other factors, such as
‘local richness or cheapness effects’
&‘potential financing advantages’
• Yield income is the easiest component to estimate
• Rolldown return is also straight forward
• The other three components are quite uncertain
5.1 Decomposing Expected Return
5.2 Estimation of the Inputs
5.3 Limitations of the Expected Return Decomposition
5 A MODEL FOR FIXED-INCOME RETURNS
Trang 46.3 Risks of Leverage
Leverage can significantly
↑the magnitude of losses even for moderate valuation declines
= × + − ×
= +
−
Leverage Portfolio Return
To recognize the significance of leverage
on returns, the above equation can be decomposed into two portions:
If > leverage ↑ the portfolio return
If < leverage ↓ the portfolio return
6.2 Methods for Leveraging Fixed-Income Portfolios
6.1 Using Leverage
• Futures contracts are important source of leverage
• LeverageFutures =
(where margin is invested equity)
6.2.2 Swap Agreements
• an important source of short-term financing
• Repos are kind of collateralized loans
• In a repurchased agreement, security owner (borrower) sell a security for cash and agrees
to repurchase it from the lender at a specific future date and an agreed on price
• Repo agreements may be cash driven or security driven
• On the basis of settlement, repos can be categorized as bilateral repos or tri-party repos
6.2.5 Security Lending
6.2.4 Repurchase Agreements
• Interest rate swaps are equivalent to long-short bond portfolio
• fixed-rate payer effectively short a fixed-rate bond and long a
floating rate bond and the value of the swap for the fixed rate payer ↑ when interest rates ↑
• fixed-rate receiver effectively long a fixed rate bond and short
a floating-rate bond and the value of the swap for the fixed-rate receiver ↑ when interest fixed-rates ↓
• Structured financial instruments are constructed to redistribute risk
• Inverse floater is a type of structured financial instrument whose coupon rate has an inverse relationship to the market interest rate e.g Coupon rate = 15% - (1.5 x Libor3-month)
6.2.3 Structured Financial Instruments
6.2.1 Future Contracts
• Two motives of security lending are i) to facilitate short selling
& ii) for collateralized borrowing or financing
• In a short selling, short seller borrows the security from someone else and then sells the security and receives immediate payment The short seller later returns the security
• In financing-motivated loan, a bond owner lends securities to investor and receives cash
• Unlike repos, security lending transactions are open-ended
6 LEVERAGE
Trang 57 FIXED INCOME PORTFOLIO TAXATION
Some common tax principles of fixed-income investments are:
• Compared to interest income, capital gains/losses are taxed at ↓ rates
• Zero-coupon bonds investors are required to pay tax on imputed interest income (i.e
amortization of discount in some countries)
• Capital losses can be used to reduce capital gains and can be carried forward or in some jurisdictions can be carried back
• In some countries short-term capital gains are taxed at ↑ rate than long-term capital gains
Some tactics to manage fixed-income portfolios for tax purposes include the following:
• Prudently cancel out capital gains and losses
• Carefully realize short-term gains if short-term capital gain tax rate > long-term capital gain tax rate
• Realized losses can be used to offset current
or future capital gains
• Extend holding periods to defer taxes
• Take into account the trade-off between capital gains and income
7.1 Principles of Fixed-Income Taxation
7.2 Investment Vehicles and Taxes
Different investment vehicles are taxed differently based on type of assets involved and jurisdiction
... fixed-rate bond and long afloating rate bond and the value of the swap for the fixed rate payer ↑ when interest rates ↑
• fixed-rate receiver effectively long a fixed rate bond and short... taxes
• Take into account the trade-off between capital gains and income
7.1 Principles of Fixed-Income Taxation
7.2 Investment Vehicles and Taxes
Different investment... kind of collateralized loans
• In a repurchased agreement, security owner (borrower) sell a security for cash and agrees
to repurchase it from the lender at a specific future date and